Column: Global signals and local noises

Sustained growth will not be easy for India without drastic reforms

Most academic writing on macroeconomics is in a closed-economy context. This has been so since John Maynard Keynes, who created a closed-economy model, despite living and working in a very open economy. Across the Atlantic, the US economists endorsed the closed-economy logic. International trade has a walk-on part, if at all, and exchange rate equations are seldom specified. There is talk of global or international macro but only talk.

Consider the latest intervention by the US Fed. Everyone was expecting that, by Taylor’s Rule, the Fed would be ready to signal a rate rise soon. But then the ECB began its QE and the euro depreciated sending the dollar up. This exchange rate appreciation is equivalent to an extra bout of deflation. With the rate of inflation already very low, this meant that the real rate of interest rose despite the near-zero nominal rate. Thus, an external shock had to be taken into account to implement a slightly-revised Taylor’s Rule policy.

It is not just this latest episode. You cannot understand the long boom of 1991-2007 without looking at the capital flows between Asia and the developed economies as well as the downward pressure on inflation due to the manufacturing exports from Asia. There are still large debts that developed economies owe to the Asian economies which may yet determine the dynamics in the next 25 years. This may mean appreciation of the renminbi vis-a-vis the dollar which may depress the Chinese economy over the medium-run. The rupee, however, fragile today may also get some backwash though it is not a creditor country.

In the immediate short run, there will be an external shock when the Fed does finally move to raise rates. The rupee will depreciate. But this time around, RBI is better prepared than the summer of 2013 when the rupee dropped drastically. There is a delicious irony here. Business types are always wishing for a lower rupee except when it happens due to an external shock. It is, by and large, a folly to try to manipulate the exchange rate. The better policy is to be well prepared for such shocks as may come from outside.

The Indian economy is being feted all around. India should beware of such praise from experts such as the IMF’s Christine Lagarde. The IMF doesn’t have a good forecasting record, in any case. But there is no room for complacency. People should disbelieve long run projections of high growth rate over the next twenty or thirty years. Stories of India outpacing China are heart-warming but they are only stories. It is not clear as yet whether the fundamentals for sustained high growth are in place. Two problems are notable. First, the good growth performance of the Indian economy during 2000-2007 was due to, in a large part, the benign international milieu. That boom was a credit-fed bubble and proved to be unsustainable. This time around there is deflation in the developed economies. The oil price is a plus but we do not know for how long it will stay low. In the meantime, all the major policy changes required for sustained growth at 8% and above are yet to be implemented. The difficulty with the Land Bill shows that this may not be easy.

India’s growth story has to be treated as an accident rather than a result of deliberate methods. It coincided with the long boom of 1991-2007. Thanks to the collapse of USSR, and the completion of WTO, the international capital markets became much more competitive and active.

Financial innovation made the transfer of capital efficient. India rode on the back of this by implementing minimal liberalising changes. But its entire political class, including the BJP, is hostile to markets and any liberal policy which would make doing business easier. Statism plus sentimental and inefficient redistribution policies are the norm.

It is now clear that the Modi government will not succeed in changing this mindset very much. It is not clear whether it wishes to challenge that mindset. The government is hoping to get back to UPA-I circumstances when growth was good without pursuing drastic reforms. It may be lucky if that turns out to be the case. But this cannot be relied upon. Local noises are making reform difficult as we have seen with the land Bill and the criticism of sensible tax changes in the Budget. If the developed economies go through a long deflationary cycle—secular stagnation, as Larry Summers has reminded us—then sustained growth will not be easy for India without drastic reforms. It does not matter that India is less open as an economy than China. That may be so in trade but not in capital account. India relies on generous FII and, hopefully, FDI for its growth story. That should caution against any complacency.